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Increasing Audit Profits Series No. 14—Maximizing Substantive Evidence from Risk Assessment Procedures—Part Two

Jun 16th 2011
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Reading (Scanning) the General Ledger

One of the most pervasive analytical procedures is reading, or scanning, the general ledger account activity.  Whether done manually, or with the assistance of data extraction software, this analytical procedure is discussed for the first time in the current risk assessment standards.

Many auditors customarily perform this procedure but fail to consider its effects on their audit strategy.  After any errors are corrected by proposed journal entries, and other unusual matters are satisfactorily explained by client personnel, the auditor has obtained significant substantive evidence that relevant assertions for many account balances are appropriate and reasonable.  The substantive evidence obtained from this risk assessment procedure should enable the auditor to reduce the assessed level of risk of material misstatement and, therefore, the extent of evidence desired from detailed tests of balances.  To say it another way, an audit strategy that maximizes substantive evidence from reading the general ledger can minimize the evidence required from more costly detailed tests of balances.

This procedure is usually performed by looking for (1) unusual amounts or postings, (2) transactions or general journal entries greater than the lower limit for individually significant items, (3) checks or disbursements to be used in support tests, and (4) other unusual matters.  Documentation of the procedure should include the parameters of the test, the exceptions the test revealed and the resolution of the exceptions in a spreadsheet, memo or other working paper.

Here are some illustrative unusual matters that could be discovered while reading an entity’s general ledger:
•    The raw materials purchases account contained five round amount payments totaling $60,000.
•    Selling expenses contained 20 expense reimbursements paid to the bookkeeper  totaling $9,500.
•    10 payments totaling $9,000 were made to an office employee and classified as office expenses.
•    Only 2 of 12 required monthly payments were made on the bank long-term debt (property mortgage) during the year.  

While reading the general ledger, or from other analytical procedures such as comparisons of account balances with a prior year on a trial balance, other unusual matters like these may be discovered:

•    Sales are up 10% ($385,000) while accounts receivable are up 40% ($143,000).  The office manager has collection responsibility and the offsite owner performs the key control of reviewing sales invoices, accounts receivable aged trial balances and collections.  It appears this key control may not be operating.  
•    Cash is down $20,000 and accounts payable are up about $30,000.  This initially appears to be due to slower accounts receivable collections and does not appear to be a control deficiency.  However, because the offsite owner may not be performing key controls, unauthorized expenditures could be the cause.  This could be potential fraud risk.
•     Inventories decreased $75,000 while sales increased $30,000 and costs of sales increased $314,000.  Since the offsite owner may not be performing key controls, unauthorized purchases may be the cause.  It is also possible unsecured inventory is disappearing due to theft or fraud.  This is a potential material weakness.
•    Operating expenses and selling expenses are up about $30,000 each. Because the offsite owner may not be performing key controls, this deficiency also could be a significant deficiency or a potential fraud risk.

A live or on-demand webcast in my Small Audit Series entitled, Developing Cost-Beneficial Audit Strategies, discusses maximizing evidence from risk assessment procedures, including reading the general ledger.  These webcasts can be accessed by clicking the applicable box on the left side of the home page on my website,



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